Know Your Market

Then and Now: Put Margins in Historical Perspective

May 03, 2013

Negative profitability during the first quarter of a year is not all that unusual. But it is possible to protect what is on the table today.

By Chip Whalen, CIH

As readers of our column and those familiar with our approach to risk management are aware, we spend quite a bit of time focusing on and analyzing opportunities in deferred time periods to protect profit margins.

A lot can happen from the time a projection is being made to when a margin will actually be realized in any given marketing period. Some things like weather events cannot be anticipated in advance and have an enormous impact on profitability. Other things may repeat seasonally year in and year out and influence the profitability profile from one time period to the next. As an example, the first quarter of the calendar year tends to be a tough one for dairy producers.

While seasonal patterns do not always play out and any particular year can be unique with its own fundamental dynamics in play, the point is that the first quarter is not always kind to dairy producers. The first quarter of 2013 was no exception. Up until quite recently, milk checks were not covering the cost of bringing that milk to market.

The fact of the matter is that negative profitability during Q1 is not all that unusual. The charts below help illustrate this. The first is a seasonal graph of first quarter milk margin indexed on a scale of 0 to 100. What this basically shows is the time of year when first quarter margin tends to be strong and other times of the year when it tends to be weak. I have circled two areas of focus on the graph.

The green circle highlights the time of the year when the first quarter’s projected profitability tends to be strong. We are in a period currently during the April-July timeframe when first-quarter margins tend to be at their highest level of the year. If you glance a bit further to the right, you will notice a red area circled that highlights the time of year when the first quarter margin tends to be the weakest. It normally occurs during the actual marketing period of the first quarter itself. In other words, if you are on the open market, you tend to realize the worst possible profit margins for that calendar quarter of the year by accepting spot feed costs and milk prices during that period.

The second chart displays the past 10 years of first quarter profit margin, including the current projection for 2014. This "stacked" view of the Q1 margin allows you to track where each of the past 10 years’ Q1 margins ended up versus what was being projected prior to the actual marketing period if you follow the individual lines back in time. Another thing this graph allows you to do is compare past years so you can see how strong or weak certain years were relative to others.

Two things stand out to me about this graph. The first is where Q1 margins typically end up. With the exception of 2005 and 2007, most first quarters are lucky to breakeven and there is a noticeable tendency for the margin to deteriorate from January into March. In fact, none of the Q1 margins within the past five years have finished in positive territory, and 2009 obviously sticks out like a sore thumb.

The second thing that strikes me about the graph is where the profit margin is currently being projected for the first quarter of next year. I drew an arrow to the current projection to show where it is on the graph. At just under $2.00 per cwt. for this particular model operation, the profit margin is currently at the 90th percentile of the previous 10 years, and exists at a very strong level from a historical perspective. It is pretty clear to see that for this particular dairy, anything between $2.00-$3.00 per cwt. would be an outstanding profit margin for Q1, and something north of $3.00 percwt. would be extremely rare within the context of history.

While I have no idea where the profit margin for the first quarter of 2014 will ultimately end up 10 months from now or what things will affect that profitability as we move through the balance of this year into next, I do know that it is possible to protect what is on the table today. Moreover, there are a variety of ways this profitability can be protected. Perhaps it would be desirable to preserve the opportunity for a potential $3.00 per cwt. margin in Q1? Maybe you would like to protect against the possibility of a catastrophe repeating itself like in 2009? Some may even be happy locking in the current projection and just walking away.

What is the best strategy? It really depends on you. Everyone will have a different outlook, tolerance for risk, comfort for contracting and access to capital that will allow them to consider different alternatives. Regardless of what strategy someone may ultimately choose, I hope you can see how projecting profit margins and putting them into an objective context by looking at history can greatly help with the decision-making process. Being a more informed decision maker is really the first step to becoming a margin manager and taking charge of your dairy’s profitability.

As Vice President of Education & Research at CIH, Chip Whalen is responsible for developing and conducting all of CIH’s Margin Management seminars. He is also the editor of CIH’s popular Margin Watch newsletters. Whalen can be reached at (312) 596-7755 or cwhalen@cihedging.com.